An Opportunity Amid the Nikkei Crash

Yesterday’s meager 0.83% decline in the S&P 500 Index might have shaken U.S. investors from their complacent state, but it pales in comparison to what happened in Tokyo overnight.

Angst over Bernanke’s testimony and weakness in U.S. markets kicked off the downturn in Japan’s Nikkei 225 Index, but the bulk of the selling pressure came following news that China’s manufacturing sector was slowing[1]. By the end of the crash, Nikkei futures had fallen a harrowing 1000 points, representing an 8.5% correction from their peak at 16020.

While both the magnitude and speed of the Japanese market’s decline is perhaps surprising, the fact that it finally went down shouldn’t be. It’s merely following in the footsteps of any asset that goes parabolic. Think of the rapid $200 drop in gold in August 2011 following the final push of its breathtaking ascent. Or the persistent plunge in Apple (AAPL[2]) after breaching $700 in late 2012.

An event like last night reminds all traders of the risks associated with chasing assets that have already climbed into the stratosphere. Remember, the Nikkei 225 Index was up a scorching 52% year-to-date before the recent bloodbath. And even with the sharp decline, it’s still up about 39%.

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On the heels of the overnight free fall, Japan-based ETFs are all gapping down this morning. Both the iShares Japan Index Fund (EWJ[4]) and WisdomTree Trust Japan Total Dividend Fund (DXJ[5]) are opening down about 7.5%.

Alhough both funds offer exposure to the Japanese economy, the DXJ is a better trading vehicle for option traders. Its higher share price ($49 vs. $11) allows the fund to offer a broader array of strike prices with sufficient premium to use in structuring positions.

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Not surprisingly, the volatile turn of events in DXJ has driven demand for protection — and hence the cost — through the roof. As shown in the chart below, implied volatility for DXJ options jumped from 28% to 38%. Traders looking at this dip in Japan as an opportunity to jump aboard its bull market at better prices could take advantage of the now-elevated option prices by selling out-of-the-money puts.

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With DXJ trading at $48.70, you could sell the July 43 puts for 95 cents. In doing so, you obligate yourself to buy 100 shares of DXJ at $43. However, to reach your strike price, DXJ would have to drop another 12% over the next month, which is relatively unlikely. Furthermore, if you do end up being assigned, your true cost basis will be $42.05 because you received 95 cents of premium at trade entry.

If DXJ remains above $43, the put will expire worthless, allowing you to pocket the 95 cents.

As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.